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Why Is The APR So High on a Payday Loan?

Written By wafa gurape on Selasa, 17 Desember 2013 | 06.36

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Unless you have been living under a rock for the past year you will have noticed the rush of companies that are fighting to offer you a short term loan. Usually called payday loans, these lending solutions provide extremely short term loans for people that need a top up to get them through to the end of the month. The loan terms are usually 1 month but they could be as short as two days or as long as three months.

Are payday loans a bad thing?

The short term loan providers have come under intense criticism, some of it justified and some not. The main criticism has been because of the apparently massive interest rates they charge. There is no doubt that payday loans can be a dangerous thing if the customer doesn't understand them but the incredibly high representative APR values that are quoted are really not a true reflection of what you are actually going to pay.

You have to realise that these payday loans are only a short term solution. If you rigidly stick to the terms and conditions of the loan and pay back the amount you borrow and in the agreed timeframe then you will typically pay around 1% per day. The key is to pay the loan back on time, if you can't pay back on time then you should contact the lender as soon as possible because you will likely pay charges if you fail to pay back within the agreed time frame.

So why is the representative APR so high?

The representative APR is a figure that is used to compare loans and other banking products. It is a representative figure that shows the interest you would pay if your loan term was a single year. Representative APR values of short term loans are typically in the thousands of percent range. This looks like an incredibly high and scary number when you compare it to the relatively low values stated by credit cards or a standard unsecured loan but really the representative APR value of a payday loan is a completely nonsense value. It is only useful to compare the short term loans against each other.

You will never, ever pay 5000% on your payday loan even though the representative APR is shown to be 5000%. The loan term is never going to be anywhere near a year, it will more likely be one month. The representative APR that is stated is calculated by scaling the daily percentage up to a year and showing you what you would pay back if that same loan was paid back over the period of a year.

Show me an example!

The example below shows how a representative APR of 5000% equates to a much lower pay back than expected if the loan term is 30 days.

Day rate % = (representative APR/365) * (loan term/365)
Day rate % = (5000/365) * (30/365)
Day rate % = 1.13%

Say for example you borrowed $100. You wanted to pay back your $100 over one month or 30 days. So over the 30 day period you would pay back your $100 plus 1.13% per day. You would pay back a total of $133.90 spread over the month, roughly $33.50 per week. There are also usually admin charges on top of this as well so you would pay back slightly more but I am keeping the numbers simple!

As you can see from the example above, although the lenders are told that they have to display the representative APR value, it is really a useless number. A more accurate figure to assess what you will actually end up paying back is the daily percentage rate that the lender charges. This will typically be around 1% but some are a little higher and some are a little lower.

So are payday loans as bad as they seem? Not as long as you pay the loan back in the agreed time frame. You should assess the product over the term period of the loan rather than just looking at the stated representative APR value, which is completely inappropriate for these types of product.
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